Chapter 5 Externalities

PROGRAM: Undergraduate Program in Management
COURSE: Microeconomics II
PROFESSOR: Dr. Wafa Mallek
TERM: Spring 2023
1
Externalities
N. G. Mankiw & M. H. Rashwan, Principles of Economics Middle East Edition,
Cengage Learning 2012, Chapter 10
2
In this chapter, look for the answers to these questions:
- What is an externality?
- Why do externalities make market outcomes inefficient?
- What public policies aim to solve the problem of externalities?
- How can people sometimes solve the problem of externalities on their
own? Why do such private solutions not always work?
© 2012 Cengage Learning EMEA.. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for
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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
Introduction
One of the Ten Principles from Chapter 1:
Markets are usually a good way to organize economy activity.
In absence of market failures, the competitive market outcome is

efficient, maximizes total surplus.
One type of market failure: externality, the uncompensated impact of

one person’s actions on the well-being of a bystander.
Externalities can be negative or positive, depending on whether impact

on bystander is adverse or beneficial.
4
Introduction
Self-interested buyers and sellers neglect the external costs or benefits of
their actions, so the market outcome is not efficient.
Another principle from Chapter 1:
Governments can sometimes improve market outcomes.
In presence of externalities, public policy can improve efficiency.
5
Examples of Negative Externalities
- Air pollution from a factory
- The neighbor’s barking dog
- Late-night music blasting from
the room next to yours
- Noise pollution from construction
projects
- Health risk to others from
second-hand smoke
- Talking on cell phone while driving
makes the roads less safe for others
6
Recap of Welfare Economics
P The market for gasoline
$5 The market eq’m
maximizes consumer +
4
producer surplus.
Supply curve shows private
3 cost, the costs directly
$2.50 incurred by sellers.
2
Demand curve shows
1 private value, the value to
buyers (the prices they are
0
willing to pay).
0 10 20 25 30 Q
(gallons)
7
Analysis of a Negative Externality
$5 Social cost
= private + external cost
4 external
cost Supply (private cost)
3 External cost
= value of the negative impact
2 on bystanders
= $1 per gallon
(value of harm
1 from smog, greenhouse
gases)
0
0 10 20 30 Q
(gallons)
8
P The market for gasoline The socially optimal
$5 quantity is 20 gallons.
Social
cost
4
S
3 At any Q < 20,

value of additional gas exceeds
social cost.
2
D
1 At any Q > 20,
social cost of the
last gallon is
0 greater than its value to
0 10 20 25 30 Q society.
(gallons)
9
$5
Social Market eq’m
cost (Q = 25) is greater
4 than
S Social optimum
(Q = 20).
3
2 One solution:
tax sellers
D
$1/gallon,
1
would shift
S curve up $1.
0
0 10 20 25 30 Q
(gallons)
10
“Internalizing the Externality”
Internalizing the externality: altering incentives so that
people take account of the external effects of their actions,
In our example, the $1/gallon tax on sellers makes sellers’ costs
= social costs.
When market participants must pay social costs, market eq’m =
social optimum.
(Imposing the tax on buyers would achieve the same outcome;
market Q would equal optimal Q.)
11
Examples of Positive Externalities
- Being vaccinated against contagious diseases protects not only you, but
people who visit the salad bar or produce section after you.
- R&D creates knowledge others can use.
- People going to college raise the population’s education level, which
reduces crime and improves government.
12
Positive Externalities
 In the presence of a positive externality, the social value of a good
includes
 private value – the direct value to buyers
 external benefit – the value of the positive impact on bystanders
 The socially optimal Q maximizes welfare:
 At any lower Q, the social value of
additional units exceeds their cost.
 At any higher Q, the cost of the last unit exceeds its social value.
13
ACTIVE LEARNING 1
Analysis of a positive externality
P The market for flu shots
External benefit
$ 50
= $10/shot
 Draw the social value
40
curve.
S  Find the socially
30
optimal Q.
 What policy would
20
internalize this
externality?
10
D
0 Q
0 10 20 30
14
ACTIVE LEARNING 1
Answers
Socially optimal Q
P The market for flu shots = 25 shots.
$ 50 To internalize the
external externality, use subsidy =
40
benefit $10/shot.
S
30
Social value
20 = private value + $10 external
benefit
10
D
0 Q
0 10 20 25 30
15
Effects of Externalities: Summary
- If negative externality, market quantity larger than socially desirable,
- If positive externality, market quantity smaller than socially desirable,
- To remedy the problem: ‘Internalize the externality’:

 Tax goods with negative externalities
 Subsidize goods with positive externalities
16
Public Policies Toward Externalities
Two approaches:
Command-and-control policies regulate behavior directly. Examples:
◦ limits on quantity of pollution emitted
◦ requirements that firms adopt a particular technology to reduce
emissions
Market-based policies provide incentives so that private decision-
makers will choose to solve the problem on their own. Examples:
◦ corrective taxes and subsidies
◦ tradable pollution permits
17
Corrective Taxes & Subsidies
Corrective tax: a tax designed to induce private decision-makers to take
account of the social costs that arise from a negative externality
Also called Pigouvian taxes after Arthur Pigou (1877-1959).
The ideal corrective tax = external cost
For activities with positive externalities,
ideal corrective subsidy = external benefit
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Corrective Taxes & Subsidies
Other taxes and subsidies distort incentives and move economy away
from the social optimum.
Corrective taxes & subsidies
◦ align private incentives with society’s interests
◦ make private decision-makers take into account the external costs and
benefits of their actions
◦ move economy toward a more efficient allocation of resources
19
Corrective Taxes vs. Regulations
Different firms have different costs of pollution abatement.
Efficient outcome: Firms with the lowest abatement costs reduce
pollution the most.
A pollution tax is efficient:
◦ Firms with low abatement costs will reduce pollution to reduce their
tax burden.
◦ Firms with high abatement costs have greater willingness to pay tax.
In contrast, a regulation requiring all firms to reduce pollution by a
specific amount not efficient.
20
Corrective Taxes vs. Regulations
Corrective taxes are better for the environment:
 The corrective tax gives firms incentive to continue reducing pollution
as long as the cost of doing so is less than the tax.
 If a cleaner technology becomes available, the tax gives firms an
incentive to adopt it.
 In contrast, firms have no incentive for further reduction beyond the
level specified in a regulation.
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Example of a Corrective Tax: The Gas Tax
The gas tax targets three negative externalities:
◦ Congestion
The more you drive, the more you contribute to congestion.
◦ Accidents
Larger vehicles cause more damage in an accident.
◦ Pollution
Burning fossil fuels produces greenhouse gases.
22
ACTIVE LEARNING 2
A. Regulating lower SO2 emissions
- Acme and US Electric run coal-burning power plants. Each emits 40

tons of sulfur dioxide per month,
total emissions = 80 tons/month.
- Goal: Reduce SO2 emissions 25%, to 60 tons/month
- Cost of reducing emissions:
$100/ton for Acme, $200/ton for USE
Policy option 1: Regulation
Every firm must cut its emissions 25% (10 tons).
Your task: Compute the cost to each firm and
total cost of achieving goal using this policy.
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ACTIVE LEARNING 2
A. Answers
- Each firm must reduce emissions by 10 tons.

$100/ton for Acme, $200/ton for USE.
- Compute cost of achieving goal with this policy:
Cost to Acme: (10 tons) x ($100/ton) = $1000
Cost to USE: (10 tons) x ($200/ton) = $2000
Total cost of achieving goal = $3000
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ACTIVE LEARNING 2
B. Tradable pollution permits
Initially, Acme and USE each emit 40 tons SO2/month.

Goal: reduce SO2 emissions to 60 tons/month total.
Policy option 2: Tradable pollution permits
Issue 60 permits, each allows one ton SO2 emissions. Give 30 permits to
each firm.
Establish market for trading permits.
Each firm may use all its permits to emit 30 tons, may emit < 30 tons and
sell leftover permits,
or may purchase extra permits to emit > 30 tons.
Your task: Compute cost of achieving goal if Acme uses 20 permits and
sells 10 to USE for $150 each.
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ACTIVE LEARNING 2
B. Answers
- Goal: reduce emissions from 80 to 60 tons

Compute cost of achieving goal:
Acme
- sells 10 permits to USE for $150 each, gets $1500
- uses 20 permits, emits 20 tons SO2
- spends $2000 to reduce emissions by 20 tons
- net cost to Acme: $2000 − $1500 = $500
continued…
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ACTIVE LEARNING 2
B. Answers, continued
- Goal: reduce emissions from 80 to 60 tons

USE
- buys 10 permits from Acme, spends $1500
- uses these 10 plus original 30 permits, emits 40 tons
- spends nothing on abatement
- net cost to USE = $1500
Total cost of achieving goal = $500 + $1500 = $2000
Using tradable permits, goal is achieved at lower total cost and lower
cost to each firm than using regulation.
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Tradable Pollution Permits
A tradable pollution permits system reduces pollution at lower cost than
regulation.
 Firms with low cost of reducing pollution
do so and sell their unused permits.
 Firms with high cost of reducing pollution
buy permits.
Result: Pollution reduction is concentrated among those firms with
lowest costs.
28
Tradable Pollution Permits in the Real World
- SO2 permits traded in the U.S. since 1995.

- Nitrogen oxide permits traded in the northeastern U.S. since 1999.
- Carbon emissions permits traded in Europe since January 1, 2005.
29
Corrective Taxes vs. Tradable Pollution Permits
Like most demand curves, firms’ demand for the ability to pollute is a
downward-sloping function of the “price” of polluting.
◦ A corrective tax raises this price and thus reduces the quantity of
pollution firms demand.
◦ A tradable permits system restricts the supply of pollution rights, has
the same effect as the tax.
When policymakers do not know the position of this demand curve, the
permits system achieves pollution reduction targets more precisely.
30
Objections to the Economic Analysis of Pollution
- Some politicians, many environmentalists argue that no one should be

able to “buy” the right to pollute, cannot put a price on the environment.
- However, people face tradeoffs. The value of clean air and water must
be compared to their cost.
- The market-based approach reduces the cost of environmental
protection, so it should increase the public’s demand for a clean
environment.
31
Private Solutions to Externalities
Types of private solutions:
- Moral codes and social sanctions, e.g., the “Golden Rule”
- Charities, e.g., the Sierra Club
- Contracts between market participants and the affected bystanders
The Coase theorem:
If private parties can costlessly bargain over the allocation of resources,
they can solve the externalities problem on their own.
32
The Coase Theorem: An Example
Mujab likes to play the saxophone.
Negative externality:
Mujab’s playing disturbs Sahar, Mujab’s neighbor.
The socially efficient outcome maximizes Mujabs’s + Sahar’s well-being.
◦ If Mujab values playing the saxophone more

than Sahar values peace and quiet, then he should keep the
saxophone.
Coase theorem: The private market will reach the efficient outcome on
its own…
33
CASE 1:
Mujab has the right to keep the saxophone.
Benefit to Mujab of playing the saxophone = $500
Cost to Sahar of Mujab’s playing = $800
Socially efficient outcome:
Mujab stops playing and gets rid of the saxophone.
Private outcome:
Sahar pays Mujab $600 to get rid of the saxophone, both Mujab and
Sahar are better off.
Private outcome = efficient outcome.
34
CASE 2:
Muhab has the right to keep on playing.
Benefit to Mujab of playing saxophone = $1000
Socially efficient outcome:
Mujab continues to play.
Private outcome:
Sahar not willing to pay more than $800,
Mujab not willing to accept less than $1000, so the saxophone stays.
35
CASE 3:
Sahar has the legal right to peace and quiet.
Benefit to Mujab of having saxophone = $800
Socially efficient outcome: Mujab keeps the saxophone.
Private outcome: Mujab pays Sahar $600 to put up with his playing.
The private market achieves the efficient outcome regardless of the

initial distribution of rights.
36
ACTIVE LEARNING 3
Applying Coase
Collectively, the 1000 residents of Green Valley value swimming in Blue

Lake at $100,000.
A nearby factory pollutes the lake water, and would have to pay $50,000
for non-polluting equipment.
A. Describe a Coase-like private solution.
B. Can you think of any reasons why this solution might not work in
the real world?
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Why Private Solutions Do Not Always Work
1. Transaction costs:
The costs parties incur in the process of agreeing to and following
through on a bargain.
These costs may make it impossible to reach a mutually beneficial
agreement.
2. Stubbornness:
Even if a beneficial agreement is possible, each party may hold out
for a better deal.
3. Coordination problems:
If # of parties is very large, coordinating them may be costly,
difficult, or impossible.
38
S U M M A RY
• An externality occurs when a market transaction affects a third party. If
the transaction yields negative externalities (e.g., pollution), the market
quantity exceeds the socially optimal quantity. If the externality is
positive (e.g., technology spillovers), the market quantity falls short of
the social optimum.
• Sometimes, people can solve externalities on their own. The Coase
theorem states that the private market can reach the socially optimal
allocation of resources as long as people can bargain without cost. In
practice, bargaining is often costly or difficult, and the Coase theorem
does not apply.
• The government can attempt to remedy the problem. It can internalize
the externality using corrective taxes. It can issue permits to polluters
and establish a market where permits can be traded. Such policies often
protect the environment at a lower cost to society than direct regulation.
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© 2012 Cengage Learning

Chapter 5 Externalities

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Chapter 5 Externalities

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PROGRAM: Undergraduate Program in Management

PROFESSOR: Dr. Wafa Mallek

TERM: Spring 2023

Markets are usually a good way to organize economy activity.

In absence of market failures, the competitive market outcome is

One type of market failure: externality, the uncompensated impact of

Externalities can be negative or positive, depending on whether impact

In presence of externalities, public policy can improve efficiency.

3 At any Q < 20,

- If positive externality, market quantity smaller than socially desirable,

- To remedy the problem: ‘Internalize the externality’:

- Acme and US Electric run coal-burning power plants. Each emits 40

- Each firm must reduce emissions by 10 tons.

Initially, Acme and USE each emit 40 tons SO2/month.

- Goal: reduce emissions from 80 to 60 tons

- Goal: reduce emissions from 80 to 60 tons

- SO2 permits traded in the U.S. since 1995.

- Some politicians, many environmentalists argue that no one should be

◦ If Mujab values playing the saxophone more

The private market achieves the efficient outcome regardless of the

Collectively, the 1000 residents of Green Valley value swimming in Blue

product EMEA.. AllorRights

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